This May was the 125th anniversary of the Dow Jones Industrial Average (DJIA). That makes it the second oldest index of stocks globally (behind the Do

Why The Dow Jones is a Lousy Index

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2021-07-24 17:30:06

This May was the 125th anniversary of the Dow Jones Industrial Average (DJIA). That makes it the second oldest index of stocks globally (behind the Dow Jones Transportation Index). While you can't trade an index by itself, there are financial instruments that track the index performance – there is over $7.6 trillion invested in these passively managed exchange-traded funds.

First, it was created in 1896 by Edward Jone to track the performance of the 12 largest industrial companies, eventually expanding to 30 U.S. companies. The criteria for being included in the index was to be "a large and respected company," the first red flag.

Indices are typically weighted. Otherwise, they would be disproportionately weighted towards smaller companies. The S&P 500, the gold standard in indices, uses a market capitalization-weighted system, so larger companies make up proportionally a more significant part of the index.

The DJIA uses a price-weighted index. Why is this bad? Companies have different amounts of shares outstanding, so price itself isn't a good indicator of the company's total value in the stock market (Berkshire Hathaway Class A stock trades at around $420,000, while Apple trades around $150). This means that DJIA overweight small stocks. For example, Travelers Companies is the smallest stock by market capitalization in the DJIA but is the 17th highest-ranked company in the portfolio.